Increase Returns Without Increasing Your Risk

In theory, Return and Risk are linked – you cannot get a higher rate of return on an asset allocation without taking more risk. However, portfolios can be inefficient and there are a number of ways we can improve your return without adding risk or changing your asset allocation. Here are five ways to increase your returns:

1. Lower Expense Ratios. Many mutual funds offer different “share classes” with different expense ratios. The holdings are the same, but if one share class has 0.25% more in expenses, those shareholders will under perform by 0.25% a year. Here at Good Life Wealth Management, we have access to Institutional shares which have the lowest expense ratio. Generally, these funds are available only to institutions or individuals who invest over $1 million. We can buy these shares for our investors, without a minimum, which frequently offer savings of 0.25% or more versus “retail” share classes.

2. Increase your Cash Returns. If you have a significant amount of cash in your holdings, make sure you are getting a competitive return. Many banks are still paying 0% or close to zero, when we could be making 1.5% to 2% elsewhere.

3. Buy Treasury Bills. If you have a bond mutual fund and it charges 0.60%, that expense reduces your yield. If the bonds they own yield 2.8%, subtracting the expense ratio leaves you with an estimated return of 2.2%. Today, we can get that level of yield by buying Treasury Bills, such as the 26-week or 1-year Bill, which have a short duration and no credit risk. If you are in a high expense bond fund, especially a AAA-rated fund, it may be preferable to own Treasury bonds directly and cut out the mutual fund expenses. We participate in Treasury auctions to buy bonds for our clients.

4. Buy an Index Fund. If you have a large-cap mutual fund, how has it done compared to the S&P 500 Index over the past 5 and 10 years? According to the S&P Index Versus Active report, for the 10-years ended December 2017, 89.51% of all large-cap funds did worse than the S&P 500 Index. Keep your same allocation, replace actively managed funds with index funds, and there’s a good chance you will come out ahead over the long term.

5. Reduce Taxes. Two funds may have identical returns, but one may have much higher capital gains distributions, producing higher taxes for its shareholders. If you’re investing in a taxable account, take some time to look at the “tax-adjusted return” listed in Morningstar, under the “tax” tab, and not just the gross returns. Even better: stick with Exchange Traded Funds (ETFs) which typically have much lower or even zero capital gains distributions. This is where an 8% return of one fund can be better than an 8% return of another fund! We prefer to hold ETFs until we can achieve long-term capital gains, and especially want to avoid funds that distribute short-term gains. We also look to harvest losses annually, when they occur, to offset gains elsewhere.

How can we help you with your investment portfolio? We’d welcome the chance to discuss our approach and see if we would be a good fit with your goals.

9 Ways to Manage Capital Gains

Investors want to rebalance or reduce their exposure to stocks without creating a large tax bill. We specialize in tax-efficient portfolio management and can help you minimize the taxes you will pay. Here are 9 ways to manage your investment taxes more effectively:

1. Use ETFs instead of Mutual Funds. ETFs typically have very little, and often zero, capital gains distributions. Actively managed mutual funds are presently sitting on very large embedded gains, which will be distributed on to shareholders as the managers trade those positions. Using ETFs gives you better control of when you choose to realize gains.

2. Donate appreciated securities to charity instead of cash. If you are already planning to give money to a charity, instead donate shares of a stock or fund which has appreciated. The charity will get the same amount of money and they will pay no capital gains on the sale. You will still get the same tax deduction (if you exceed the now higher standard deduction) plus you will avoid paying capital gains. Use the cash you were planning to donate to replenish your investment account. Same donation, lower taxes.

Consider funding a Donor Advised Fund and contributing enough for several years of charitable giving. If you give to a large number of charities, it may be easier to make one transfer of securities each year to the Donor Advised Fund, and then give to the charities from the Fund.

3. Give appreciated securities to kids in the zero percent capital gains bracket. Some taxpayers in the lower brackets actually pay a 0% capital gains rate. If your grown children are no longer dependents, and would qualify, they may be able to receive the shares and sell them tax-free. Just be sure to stay under the $15,000 annual gift tax exclusion per person. For 2018, the zero percent capital gains rate will apply to single taxpayers under $38,600 in income and married couples under $77,200.

4. Harvest losses annually. Those losses give you the opportunity to offset gains and rebalance your portfolio. Any unused losses will carry forward to future years without expiration. And you can also use $3,000 a year of losses to offset your ordinary income, which means that instead of just saving 15-20% in taxes you could be saving 37% or more.

5. Develop a Capital Gains Budget. It’s not all or nothing – you don’t have to sell 100% of a position. We can trim a little each year and stay within an annual capital gains target. We also can sell specific lots, meaning we can reduce a position and choose to sell shares with the highest or lowest cost basis.

6. Wait a year for long-term treatment. We try to avoid creating gains under 12 months. The long-term rate is 15% or 20%, but short-term gains are taxed as ordinary income.

7. Use your IRA. If you have a well diversified IRA, we can often rebalance in that account and not create a taxable event. While many investors put taxable bonds in IRAs and leave the equities in a taxable account, for taxpayers in a high bracket, you may prefer to buy tax-free municipal bonds in the taxable account and keep equities in the IRA.

8. Stop Reinvesting Distributions. If your position in a stock or fund has grown, don’t make it larger through reinvestment of dividends and distributions! Reinvesting takes away your choice of how to rebalance your portfolio with the cash flow you receive. However, please make sure you are doing something with your distributions in a timely manner and not letting them accumulate in cash.

9. Just take the Gains already! Don’t let a gain disappear because you don’t want to pay 15% in taxes. If you have a big winner, especially with an individual stock or a speculative investment like bitcoin, take your gains and move on. If we become too obsessed with taxes we run the risk of letting our investment returns suffer.

While most people are thinking about their 2017 taxes right now, reacting to what has already passed, we suggest looking ahead to 2018 and being proactive about managing your futuretax liabilities. Taxes can be a significant drag on performance. If you’re investing in a taxable account, we can give you peace of mind that you have a plan not only for financial security, but also to manage your capital gains as efficiently as possible.

Advantages of Equal Weight Investing

The four largest stocks in the United States are all tech companies today: Apple, Microsoft, Amazon, and Facebook. For 2017, these stocks are up significantly more than the overall market, 49%, 38%, 55%, and 52% respectively.

These are undoubtedly great companies, but as a student of the markets, I know you can look at the top companies of previous decades and notice two things. First, top companies don’t stay at the top forever, and second, the market goes through phases where it loves one sector or industry more than it should. (Until it doesn’t…)

And this is the knock on index funds. Because they are weighted by market capitalization, an index will tend to own a great deal of the over-valued companies and very little of the under-valued companies. The top 10 stocks of the S&P 500 Index comprise nearly 20% of its weight today. If you go back to 1999 and look at the valuation of the largest tech companies like Cisco, you can see how those shares were set up for a subsequent period of substantial and prolonged under-performance.

In spite of this supposed flaw in index funds, the fact remains that typically 80% of all actively managed funds perform worse than their benchmark over any period of five years or longer. If the index is hampered by all these over-valued companies, why is it so difficult for fund managers to find the under-valued shares? One possible reason is that the higher expense ratio of an active fund, often one percent or more, eats up the entire value added by the manager.

But there is an interesting alternative to market cap weighting, which avoids over-weighting the expensive stocks. It’s equal weighting. If you have 500 stocks, you invest 0.2% in each company. Your performance then equals that of the average stock, rather than being dependent on the largest companies. To remain equal weight, the fund will have to rebalance positions back to their 0.2% weight from time to time.

There have been extensive studies of the equal weight process, most notably by Standard and Poors which calculates an equal weight version of their S&P 500 Index, and by Rob Arnott, of Research Affiliates, who wrote about equal weighting in various papers and in his 2008 book “The Fundamental Index.”

But even better than studies, there has been an Equal Weight ETF available to investors since April 2003, a 14-year track record through Bull and Bear Markets. The results have been compelling.

– Since inception in 2003, the S&P 500 equal weight fund has had an annual return of 11.21% versus 9.53% for the cap-weighted S&P 500 Index.
– Equal Weight beat Market Cap over 57% of the one-year periods, on a rolling monthly basis since the fund started in 2003. However, the fund out performed over 84% of the five-year periods and 100% of the 10-year periods.
– You might think that by reducing the supposedly over-valued companies, the fund would have lower volatility, but that has not been the case. Instead, the fund has had a slightly higher standard deviation and actually lost more in 2008 than the cap weighted index. It’s no magic bullet; it’s primary benefit appears to be return enhancement rather than risk reduction.

We plan to add an Equal Weight fund to our portfolio models for 2018. Although some of our concern is that today’s tech stocks dominating the index are over-valued, we should point out that there is no guarantee that Equal Weight will be better than the Cap Weighted approach in 2018 or in any given year. However, for investors with a long-term outlook, the approach does appear to offer some benefits in performance and that’s the reason we are adding it to our portfolios.

Before August, the cheapest fund offering an equal weight strategy had an expense ratio of 0.40%. However, there is a new ETF that offers the strategy at an ultra-low cost of only 0.09%, which makes it very competitive with even the cheapest cap weighted ETFs.

If you have any questions on the approach, please feel free to email or call me. For positions in taxable accounts, we have significant gains in many portfolios. In those cases, we will not be selling and creating a taxable event. But we will be purchasing the new fund in IRAs and for purchases going forward.

Source of data: Morningstar.com and from Guggenheim Investments All Things Being Equal dated 9/30/2017.

Big Changes to Ameritrade’s ETF Platform

Exchange Traded Funds (ETFs) are a terrific vehicle for investors, offering an easy way to build diversified portfolios that are transparent, tax efficient, and low cost. We’ve written frequently about the advantages of ETFs and hold them as core positions within all of our portfolios.

This week, our custodian, TD Ameritrade, announced that it was expanding its platform of commission-free ETFs from 100 to nearly 300 funds. Wonderful, right? Not so fast… while the total number of ETFs will increase, they are actually dropping 84 low-cost ETFs, including ALL of the Vanguard ETFs we use for each and every client.

To say that we are disappointed and frustrated is an understatement. We are big fans of Vanguard and have used these funds since we opened three years ago. They are among our largest holdings. Why is TD Ameritrade dropping these funds? Distribution fees. Vanguard does not pay custodians to distribute their funds, but other companies will pay TD Ameritrade to be on their commission-free platform.

As a whole, the changes to the TD Ameritrade platform are appalling to me. We lose low cost ETFs from Vanguard and the iShares Core series, and instead are offered mainly niche ETFs with high expense ratios. Many of the new ETFs are focused on a very narrow area such as the “nasdaq smartphone index” or the “dynamic pharmaceuticals” ETF. This approach is antithetical to our process of diversification. Sometimes being given more options does not mean that you have better choices.

There is one bright spot: they are adding the new SPDR Portfolio Series from State Street. State Street is one of the three largest ETF providers, along with Vanguard and iShares, and is the creator of the original S&P 500 ETF, SPY,  which launched the whole ETF movement nearly 20 years ago.

In recent years, State Street has been struggling to keep up with lower cost competition from Vanguard, Schwab, iShares and others. The new Portfolio Series took a handful of their most diversified ETFs, many with track records of over 10 years, and slashed the expense ratios to levels at or below even Vanguard. These will be our new go-to funds.

We can of course, continue to buy and sell the Vanguard ETFs through TD Ameritrade. However, after November 16, those trades will incur a standard commission (as low as $6.95). And that is still a bargain. Should we drop our Vanguard funds in the next month, while they still trade for commission-free?

Here is our plan:

1. In taxable accounts, we may have significant capital gains in our Vanguard positions. It does not make sense to realize thousands of dollars in gains just to avoid a $6.95 commission. (If we had losses, we would harvest those losses, but the market is up nicely this year. I’m not complaining!)

2. Even when there is zero commission, there are still trading costs. Just like stocks, ETFs trade in an auction process where buyers offer a “bid” and sellers request an “ask” price. The Vanguard ETFs are heavily traded, sometimes with multiple trades in one second. The difference between the bid and ask price, the “spread”, is often only one cent.

However, on ETFs that trade less frequently, the spread can be much higher. I looked at a small-cap value ETF this week that had a 14 cent spread. So, even in non-taxable accounts like IRAs, there may still be a hidden cost if we were to sell Vanguard to buy the SPDRs. As trading volume increases, I anticipate bid-ask spreads will tighten on the newly added funds. But for larger positions, selling one ETF at the bid and buying another at the ask could certainly cost more than the $6.95 commission we are trying to avoid.

3. For new purchases, we will use the SPDR Portfolio Series, effective immediately. They trade commission-free and in many cases have a lower expense ratio than a comparable Vanguard Fund. Existing portfolios will continue to hold Vanguard Funds. This means that many portfolios will unfortunately now have some duplication, where for example, we might own a Vanguard International ETF and also own a similar SPDR International ETF. I try to avoid that sort of redundancy, but it does not really cause any harm.

4. In IRAs with smaller positions, we will look to sell Vanguard within the next few weeks and replace those positions with a new commission-free option. We will still be needing to rebalance portfolios annually, in which case, it is nice to be able to do so commission-free. These trades will be done on a case-by-case basis.

Please feel free to email or call me with any questions. This change at TD Ameritrade has created some temporary hassle, and received quite negative press on Wealth Management.com and in a scathing piece by Michael Kitces.

This change isn’t going to detract from our approach or impact our investment process. We start with a top down asset allocation and then choose the best fund to fulfill each segment of our allocation. We certainly don’t limit our search for investments to just commission-free ETFs, and have always also had mutual funds or ETFs that are not on the commission-free platform. As your Fiduciary, we take seriously our responsibility to keep fees as low as possible, but it’s not true that the lowest cost is always the best investment option.

Beware: 2017 Fund Capital Gains Distributions

We are starting to receive estimates for year-end 2017 Capital Gains distributions from Mutual Funds, and no surprise, many funds are having large distributions to their shareholders this year. As a refresher, when a mutual fund sells a stock within its portfolio, the gain on that sale is passed through to the fund owners at the end of the year as a taxable event.

When you invest in a 401(k), IRA, or other qualified account, these capital gains distributions don’t create any additional taxes for you. If you reinvest your distributions, your dollar value of the fund remains the same, and you are unaffected by the capital gain. However, if you are investing in a taxable account, these distributions will cost you money in the form of increased taxes.

A quick look at estimates from American FundsColumbia, and Franklin-Templeton shows that many equity funds are having capital gains distributions of 3-10% this year. A few are even higher, such as the Columbia Acorn (17-21%) and Acorn USA (23-28%). Imagine if you made a $100,000 investment at the beginning of the year, your fund is up 16% and then you get a distribution for $28,000 in capital gains! Yes, capital gains distributions can exceed what a fund made in a year, when the fund sells positions which it owned for longer.

Capital Gains Distributions create a number of problems:

  • Even if you are a long-term shareholder, when the fund distributes short-term gains, you are taxed at the higher short-term tax rate.
  • If you didn’t sell any of your shares, you will need to find other money to pay the tax bill, which can run into the thousands each year if you have even just a $50,000 taxable portfolio.
  • If you are thinking of buying mutual fund shares in Q4 of this year, you could end up buying into a big December tax bill and paying for gains the fund had 6-12 months ago.
  • In addition to paying capital gains on fund distributions, you will still have to pay tax when you sell your shares.
  • Capital gains distributions are in addition to any dividends and interest a fund pays. In general, we want dividends and interest income as additions to our total return. Capital gains distributions, however, do not increase our return and are an unwelcome tax liability.

If you have a taxable account, or both taxable and retirement accounts, we may be able to save you a substantial amount of money on taxes. We can use tax-efficient investments like Exchange Traded Funds (ETFs), which typically have little or ZERO capital gains distributions at the end of the year. This puts us in control of when you want to sell and harvest your gains. When you have multiple types of accounts, we can place the investments into the best account to minimize your tax bill.

If you do presently have mutual funds in a taxable account, it may be a good idea to take a look at your potential exposure before the end of the year so you are not surprised. If you sell before the distribution is paid, you can avoid that distribution. Now that will mean paying capital gains based on the profit you have when you sell. But you definitely want to be planning ahead. When you’re ready to create a tax-managed portfolio that looks at all your accounts together, we can help you do that.

Do You Receive Mutual Fund Capital Gains Distributions?

I always ask prospective clients to bring a copy of their most recent tax return and often learn a wealth of information reviewing their taxes. In doing such a review last week, I noticed that in the previous year, a prospective client had to pay taxes on $13,875 in taxable capital gains distributions from their mutual funds.

If your mutual fund is inside of a 401(k) or IRA, capital gains distributions don’t matter. However, when a mutual fund is held in a taxable account, you end up paying taxes on capital gains distributions even though you didn’t sell the position. Instead, you are paying taxes for trading the fund manager does inside the portfolio, or worse, to provide liquidity to other shareholders, who sold before December and left you holding the bag to pay for their capital gains.

Luckily, there is a better way. In my previous position working with high net worth families, the majority of assets were held in taxable portfolios. We had a number of families with $10 million to over $100 million in investments with our firm. Needless to day, I spent considerable time in looking at ways to reduce taxes, and became very effective at the process of Portfolio Tax Optimization. I offer this same approach and benefits to my clients today.

Vanguard studied the value advisors bring through planning skills like tax optimixation. They estimate that “Advisor’s Alpha” can add as much as 3% a year to your net returns.
Link: Quantifying Vanguard Advisor’s Alpha

If you have significant assets in taxable accounts, I can help you. Here are five ways we can lower your taxes and allow you to keep more of your hard earned principal:

1) Use ETFs. The prospective client with $13,875 in capital gains distributions, had approximately $600,000 in mutual funds. I created a spreadsheet that calculated capital gains if they had been invested $600,000 in my 60/40 portfolio instead. Most of my holdings are Exchange Traded Funds (ETFs), which due to their unique structure, are much more tax efficient than mutual funds. In fact, my nine ETF holdings had total distributions of zero in the same year .

In the 60/40 model, we also had five mutual funds in categories where there are not equivalent ETFs. My calculation of capital gains distributions: $2,167. So, if we had been investing for this client, their capital gains distributions could have been reduced from approximately $14,000 to $2,000. The investment vehicles we choose matter!

I should note that this is just looking at capital gains distributions. Both ETFs and mutual funds also pay interest and dividends, which are taxable. There is more to managing taxes than just picking ETFs.

2) Asset Location. We could have further reduced taxes by choosing where to place each holding. Some funds generate interest, which is taxed as ordinary income, where as other funds generate qualified dividends, which is taxed at a lower rate of 15-20%. We place the funds with the greatest tax liability into your IRA or other qualified account, to reduce your overall tax burden. Funds that have little or no distributions are ideal for taxable accounts.

3) Avoid short-term capital gains. If you sell an investment within a year, those short-term gains are taxed as ordinary income, your highest tax rate. After 12 months, sales are treated as long-term capital gains, at a lower rate of 15-20%. We do not sell or rebalance funds before one year to avoid short-term gains. Unfortunately, many mutual fund managers don’t have any such tax mandate, so oftentimes, a significant portion of fund’s capital gains distributions are short-term.

4) Tax Loss Harvesting. At the end of each year, we review taxable portfolios for positions which have declined. We harvest those losses and immediately replace each position with a different fund in the same category (large cap, international, etc.). This fund swap allows us to use those losses to offset other gains or income, while maintaining our target asset allocation. If realized losses exceed gains, you can use $3,000 of losses to reduce ordinary income. Remaining losses are carried forward to future years.

5) Municipal Bonds. For investors in a higher tax bracket, your after-tax return may be better on tax-free municipal bonds than on taxable bond funds. However, an advisor will not know this without looking at your tax return and determining your tax bracket. That’s why we make planning our first priority, before making any investment recommendations. (Would you really trust anyone making investment recommendations without knowing your full situation? Are those recommendations designed to profit them or you?)

We take a disciplined approach to managing portfolios to minimize taxes, and it is a valuable benefit to be able to customize our approach for each individual client.

On this same client’s tax return, I realized that they did not deduct their Investment Management fees, a $6,000 miscellaneous deduction.
Link: Are Investment Advisory Fees Tax Deductible?

If you have taxable investments, we may be able to save you thousands, too. Let’s schedule a call today. You deserve a more sophisticated and efficient approach to managing your wealth.

Are Smart Beta ETFs Right for You?

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Over the past several years, you may have heard about “Smart Beta ETFs”. Today, we will look at this concept and share some very important caveats that investors should know before they purchase a Smart Beta ETF for their portfolio. While the name sounds like it would be a sure thing, it is important for investors to understand that there is no guarantee that Smart Beta products will be able to deliver on their promises.

The first ETFs were all index funds, tracking major indices like the S&P 500 or the Dow. As ETFs grew in popularity, investment companies quickly added products representing other indices, sectors, styles, and countries. ETF companies will continue to create hundreds of new products each year to raise new assets and be able to charge more fees. Once every traditional index was replicated in an ETF, companies had to find more creative offerings. Will every product work and be successful? No, but there is such a pronounced first-mover advantage in the industry that many companies are willing to take the risk of launching dozens of new funds hoping that some will be a success.

The knock on traditional index ETFs is that they are weighted by market capitalization. That simply means that each stock is represented according to its total market value. What’s wrong with that? If you went back to 1999, Cisco briefly became the largest stock in the world, trading at over 100 times earnings. At that time, it represented more than 3% of every index fund. And when the stock fell by 90% during the tech crash, every index fund had a large loss. The problem with traditional index funds is that they have too much of the overvalued stocks and too little of the undervalued companies.

Smart Beta ETFs seek to avoid this issue of overweighting the most expensive stocks by using alternative weighting or selection criteria. Like an Index, Smart Beta is a hands-off strategy that is quantitatively driven and passive. There are quite a few different approaches to Smart Beta, including weighting by:
– Dividends (stocks represented by the size of their dividend stream)
– Volatility (emphasizing the Lowest Volatility stocks or combination of stocks)
– Fundamentals (such as book value, sales, or earnings)
– or even, equal weighted, where each company receives the same weight in the fund.

Here are five points you should consider before selecting a Smart Beta ETF.

1) Traditional indexing works well.
While the concern of overweighting expensive stocks sounds legitimate, I’d like to point out that in spite of this supposed flaw, a vast majority of actively managed funds fail to beat their benchmark over five years. According to the S&P Index Versus Active report, as many as 80% of active managers fall short. If it was so easy to pick out the undervalued stocks from the overvalued stocks, wouldn’t more fund managers be able to beat the market cap weighted index?

Everyone is looking for a way to out perform the market, but this remains very difficult to do. It will be interesting in 10 years to see how many of today’s Smart Beta products will have delivered superior returns.

2) Back-tested strategies do not always work as well going forward.
Smart Beta ETFs are created based on academic research looking at factors which would have produced strong returns historically. This is generally done using back-tested data, which gives us another concern. If we looked at stocks from 2000-2015, it was a very unusual period. Will the factors which worked over the past 10 or 15 years continue to generate market beating returns over the next 10 or 15 years? No one knows the answer to that; the future could be quite different than the past and back-tested strategies may not perform as hoped.

3) Smart Beta may be out of favor for extended periods.
The back-tested results look promising, with Smart Beta strategies beating their benchmarks, had the ETFs existed. While the long-term hypothetical returns look good, there can be stretches when this strategy is out of favor. It may have outperformed over 10 years, but it may have lagged in four, five, or even six of those years, only to make it up by strong performance in a couple of years. If you buy a Smart Beta ETF today, will you hold on to it if it lags the market for two years in a row? Three years in a row?

Some Smart Beta strategies correlate strongly with Value and will lag when Growth is in favor. Other strategies are defensive and will trail the market during bull markets and only enhance performance in bear markets. This makes for a difficult decision as to whether or not the current market is the right environment for a particular approach or factor. This creates the potential for market timing errors if investors chase returns by switching from one ETF to another, trying to capture the most advantageous style for any given year.

4) Smart Beta ETFs may be less diversified.
Since Smart Beta funds emphasize certain characteristics such as dividends, the funds may have a high concentration in specific sectors such as utilities, financials, or energy. In the years where those sectors perform poorly, Smart Beta funds could be volatile and disappointing.

5) Costs
Lastly, it’s not certain that the benefits of all Smart Beta funds will accrue to investors once we factor in the expense ratio, trading costs, and taxes. Luckily, ETFs are becoming highly competitive in terms of expenses, so many funds launched in the last two years have extremely low expense ratios. While we know the expense ratio, we don’t know what trading costs are incurred when a Smart Beta strategy buys and sells stocks, which most do on a quarterly or annual basis.

I’ve listed these five concerns about Smart Beta ETFs because I want to dispel the notion that these funds are a sure bet. However, I do think they are interesting and show promise. Perhaps some will deliver results. And this is another conundrum for investors: there are so many flavors of Smart Beta strategies today that we run the risk of picking the wrong one, and we end up with the fund that under performs. So this is not the simple choice of just replacing all of your traditional ETFs with a Smart Beta version and being guaranteed better results.

We’ve spent a lot of time analyzing Smart Beta ETFs and have included several in our clients’ portfolios. If you are looking to hand off your portfolio management to a professional, we are here to help. And while we manage your funds, we also take the time to explain our process, philosophy, and why we own each position.

Exchange Traded Funds Gain in Popularity

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According to a report from Blackrock this week, investors poured $347 Billion in Exchange Traded Funds (ETFs) in 2015. In recent years we have seen the shift from mutual funds to ETFs continue and even accelerate. While we don’t have numbers for mutual funds for 2015 quite yet, according to the Investment Company Institute, investors had already pulled $47 Billion from mutual funds as of November 30, 2015.

Even though ETFs continue to take market share from mutual funds, I find that many folks who have invested primarily in a 401(k) still aren’t very familiar with ETFs. Here are some of the reasons we are big fans of ETFs.

  • ETFs generally use passive strategies, such as tracking an index, or selecting stocks based on specific criteria. Since the majority of active managers fail to beat their benchmark over five years, passive strategies are a logical choice.
  • ETFs are very low cost, since passive strategies don’t require a large research staff or highly paid managers. And in a low return world, it can be very difficult for an actively managed fund with 1.10% in expenses to beat a passive ETF which has expenses of 0.10%.
  • ETFs are typically more tax efficient than mutual funds. Quite a few mutual funds distributed capital gains at the end of 2015. If you held those funds in a taxable account, you’d owe taxes, even though you didn’t sell any of your shares. If you had ETFs in your taxable account, your tax bill may have been much, much lower, or even zero.
  • ETFs offer diversification, transparent holdings, and style consistency. That’s why they make great building blocks to construct an efficient portfolio.

Wonder how your mutual funds stack up against ETFs? Call me for a free portfolio review and we will be happy to take a look and share our recommendations.

Why You Need to Drop Your Mutual Funds for ETFs

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We just finished the third quarter this week and it was a tough one. The market struggled to make new highs all year before it finally ran out of steam during the week ending August 21. The S&P 500 Index traded above 2100 in July, but dropped roughly 10% to 1920 to close the quarter on September 30. Year to date, the index is down 6.75%.

While it was a disappointing quarter, we should remember that we’ve had an exceptionally long run without a correction of any size. Still, no one likes to open their quarterly statements and see that their accounts are down.

One of the myths of active fund management is that managers are able to add value during corrections through their defensive strategies. At least, that’s what we’re told when they lag during a bull market. So how did actively managed funds fare during the third quarter?

According to a report this week by JPMorgan, 67% of active funds performed worse than their benchmark in Q3. Half of those funds (34%) lagged their benchmark by at least 2.50%.

The long-term picture is even worse for active management. The Standard & Poors Index Versus Active (SPIVA) Scorecard was recently updated with data through June 30, 2015. They found that over the past 10 years, 79.59% of all Large Cap funds were outperformed by the S&P 500 Index. Over this period, the index produced an annualized return of 7.89%, versus 7.03% for the average large cap fund.

If you are still using actively managed mutual funds, chances are good that 1) your Q3 returns are even uglier than the overall market, and 2) your long-term performance has suffered significantly. That’s why we use Index Exchange Traded Funds (ETFs) as the core positions in our model portfolios. Investing in an index doesn’t mean “settling” for average returns, it has actually been the most likely and consistent way to ensure your performance is better than the average active fund.

If that isn’t enough to get you to trade in your mutual funds for an ETF portfolio, then read this article from Morningstar on mutual fund capital gains. Morningstar notes that after a 6-year rally, many mutual funds have used up their tax losses and are increasingly likely to distribute capital gains to fund shareholders at the end of this year. If this quarter’s drop causes a large outflow of capital, active fund managers will be forced to liquidate positions, creating a tax bill for the shareholders who remain in December.

It’s entirely possible for an actively managed mutual fund to be down for the year and still create capital gains for shareholders, due to trading within the portfolio. We haven’t seen this scenario in a number of years, but it looks like a distinct possibility for 2015. Index ETFs on the other hand, are extremely tax-efficient; it is quite rare for an equity index ETF to distribute capital gains, thanks to their unique structure.

If you’re a client, thank you for sticking with the plan when the market is down. We know it is frustrating. Corrections are a natural and inevitable part of the market cycle. You can take solace knowing that our Index ETF approach is demonstrating its merit both in its relative performance in Q3 and in its long-term outperformance over actively managed funds.

If you’re not currently a client, please give me a call and we can discuss how our disciplined portfolio management process can help you accomplish your financial goals. While we can’t control what the market is going to do, we can benefit greatly by focusing on what we can control, including tax efficiency, minimizing expenses, diversification, and using a time-tested index methodology.